Interest, Rent, and Profit II and Distribution of Income

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1. Kyle is confused. He has incurred a balance on his credit card on which he pays interest at an annual rate of about 18%. Then, he reads that the interest rate that the Federal Reserve charges to banks is currently 4.75%.

This difference is best attributed to the risk of default.

2. Read No Evil (RNE) is a firm specializing in the destruction of sensitive documents. An industrial paper shredder costs $10,000. If bought, it would raise RNE's revenues by an additional $1,000 per year. The machine will last forever and never require maintenance. Which of the following statements is true?

B. The cost of money is the interest rate. RNE has the choice between investing the $10K in the machine, or in some other instrument. If the revenue generated from some other investment (at the interest rate) is less than that it can get from buying the shredder, than it should buy the shredder.

What amount of money today is equivalent to $1,100 one year from now, if banks are paying an interest rate i = 10% per year? In other words, what is the present value of $1,100 received one year from now, when interest rates are 10%?

3.1 When the price of capital increases, the return on each dollar invested in tractors declines. This would cause a decrease in the demand for loanable funds (the demand curve shifts in).

3.2 The demand for loanable funds takes into account the return on the investment. As the price of agricultural products increases, owning tractors becomes more lucrative. This causes an increase in the demand for loanable funds.

3.3. When the government decreases taxes in interest income, it becomes more lucrative to save money instead of buying tractors. This will increase the supply of loanable funds, and decrease the demand for loanable funds.

4. The concept of present value gives the equivalent in dollars available immediately to a payment that is made at some point in the future.